Don’t let distractions thwart ESG focus

It’s difficult sticking to long-term investment strategies when the political landscape is in a state of flux. Yet now, more than ever, investors need to stay focused on the long term and ignore short-term distractions. The latest report from data provider MSCI, 2017 ESG Trends to Watch, urges investors to act with vigilance and assert their influence as “owners rather than traders of an asset” in the year ahead.

“The year ahead has the potential to test institutions and portfolio companies that espouse a long-term orientation,” say report authors Linda-Eling Lee, global head of environmental, social and governance research at MSCI, and Matt Moscardi, head of financial sector research.

“The temptation to time the market in response to, or in anticipation of, real or rumoured events could prove too powerful a distraction for many. But for investors committed to the long term, 2017 may be the year to differentiate themselves from the pack and orient towards future decades.”

Owning the long game will combine with other key trends throughout 2017. More investors will mitigate their exposure to the physical risks of climate change, and push for improved stewardship from Asian companies. There will also be a jump in the adoption of the UN Sustainable Development Goals as a framework for investment, while China and India will continue to transition to low-carbon economies.

Short-termism and anticipated deregulation

The prospect of a new wave of deregulation is one area that could tempt short-termism from companies and investors. But policy is forged by forces that unfold over more than one election cycle.

Companies seemingly poised to benefit from softer regulation will, in fact, limit their sustainable growth trajectories because they will be hit by competitive disadvantage and the consequences of more lax governance in the long term. Lee and Moscardi ask: Will penalties be eliminated if regulation is relaxed? What will the long-term costs be when regulation is reinstated?

A mooted beneficiary of deregulation is US coal, a worry for those who have divested their US coal assets. Yet coal suffered because it couldn’t compete with cheaper gas, which many US utilities now use.

“What will the new (US) administration do to bring back coal? Will it stop fracking?” Lee asks. She concludes, “It will be difficult for coal to be resurgent.”

Investors also have the option to reduce, rather than divest, their coal assets; many have chosen to reweight their holdings to have exposure to the whole energy sector.

“The reweighting approach doesn’t require a take on timing.”

Physical risks will take prominence

Despite such concerns, Lee and Moscardi predict the risk focus will shift away from regulation in 2017.

“The regulatory focus obscures the more fundamental risk: weather patterns can impact assets in a physical way,” they state.

This year, investors should increasingly look at the impact of the physical risk of climate change on asset values. The experience of the US insurance market explains why. Many US homeowners have moved to government-subsidised insurance because private insurers will no longer bear the risks of an increase in the intensity of storms, or the rise of sea levels, on their own.

“Sea levels are rising. That is a fact,” Lee says. “Investors need to address these changes, regardless of who is at the helm in the US.”

Physical risk is definitely on the mind of France’s €36.3 billion ($41 billion) Fonds de Réserve pour les Retraites. The fund, which was created in 2001 to build reserves for the country’s public pension system, kicked off 2017 by identifying the risks arising from climate change in its portfolio, including physical dangers.

Elsewhere, Canada’s C$18 billion ($14.1 billion) OPTrust, which manages pension assets for former and current public-service employees in the state of Ontario, has just release detailed analysis of the potential risks to its investment portfolio from global warming. The analysis, prepared by consulting firm Mercer, predicts the fund’s investment returns could improve with modest warming, but will decrease if there is a major impact on global temperatures this century.

OPTrust states: “The physical impacts of climate change, such as extreme weather events and sea level rises, are expected to be relatively limited over the period to 2050. Nevertheless, the post-2050 implications should not be ignored.”

In an argument that contradicts conventional wisdom that sustainable investment in Asia lags behind that in Europe, six of the 14 countries that have developed stewardship codes since 2014 are in Asia. The codes, modelled after the UK Stewardship Code, set out principles that aim to improve engagement between investors and companies to increase long-term, risk-adjusted returns.

Progress in Japan has come from investment managers taking a more active role on ESG.

In a survey conducted by Japan’s giant Government Pension Investment Fund (GPIF), 60 per cent of its investee companies reported changes in their interactions with GPIF’s external managers. Elsewhere, Taiwan’s $46.7 billion Bureau of Labor Funds has committed $2.4 billion to socially responsible investments. However, the authors do flag Japan’s ageing working population, which is forecast to shrink 12 per cent in the next 10 years, as a worrying long-term risk for economic growth.

ESG grows up

This year will also mark a shift in the conversation – from how ESG matters to where it matters. Examples of the increasing sophistication of ESG strategies include research from Cambridge Associates showing that they make a stronger contribution to the performance of companies in emerging markets than to those in developed markets.

Barclays research showed strong management qualities are also likely to result in greater fiscal responsibility and fewer corporate credit downgrades.

Research also suggests that ESG and factor exposures have a relationship that can either enhance or interfere with investment goals. ESG can complement some defensive strategies that focus on lower volatility or higher quality companies. Conversely, adding ESG characteristics to a momentum strategy made for a “more difficult marriage”.

Blending factor exposures and ESG is one strategy recently adopted by HSBC Bank Pension Scheme, the fund for the HSBC Group’s UK employees. Its new multi-factor global equities index fund incorporates a climate tilt with the four factors: value, low volatility, quality and size. The fund’s bias is towards smaller, not larger companies. The climate element to the index tips away from exposure to carbon emissions and positively towards green revenue.

Sustainable development goals on the rise

Expect more investors to use the UN’s sustainable development goals as a framework for responsible investment throughout 2017. Relating to challenges around climate, poverty, healthcare and education, the SDGs require an estimated annual $5 trillion to $7 trillion by 2030.

“We will all hear a lot more about SDGs, even though they were not designed with the private sector in mind,” Lee says.

China and India will continue to transition to low-carbon economies. China is laying the foundations for a green financial system with initiatives including subsidies for loans that finance renewable energy, guidelines from the People’s Bank of China that govern issuance of green bonds, tradeable environmental indices, and a national carbon trading scheme.

“If China is to attract global capital, it needs to meet global standards,” Lee says. In 2017, global investors will be able to take “a serious look” at allocating investment, she predicts.

India is aiming to lower the emissions intensity of its gross domestic product by up to 35 per cent, compared with 2005 levels, by 2030. It also wants to quadruple renewable energy capacity in the next five years. Renewable energy has been deemed a priority lending sector for banks, and the Securities and Exchange Board of India has issued voluntary green bond guidelines.

It’s too early to declare that these economies will take on the mantle of global leadership in the transition to a low-carbon economy. But their transitions make up just one of the exciting trends of 2017.